All Bets Are Off

By TODD G. BUCHHOLZ

Published: July 31, 2003

SAN DIEGO—The so-called terrorism futures market sounded like a hoax: investors would have been able to make money from attacks and strife. Now that the red-faced Pentagon has closed down the project, it's appropriate to ask, "What were they thinking?"

The Department of Defense argued that markets "are extremely efficient, effective and timely aggregators of dispersed and even hidden information . . . often better than expert opinions." That's true. The University of Iowa has a neat system allowing bettors to establish the odds for candidates in races in America and overseas. The Iowa markets have generally done a better job than pollsters at predicting the outcomes of elections. Markets also do a great job at more traditional tasks, like matching buyers and sellers and setting prices for everything from chickens to semiconductor chips.

Still, the Pentagon's concept is flawed. Markets are not very good at setting prices for rare events. Those who trade in the Iowa political exchange have the benefit of historical election results and daily polls; property insurance companies know full well when the Florida hurricane season starts. But could markets have given us a price for the odds of a shooting in the balcony of City Hall in New York? Sure, markets learn from experience. It's been a long time, though, since Aaron Burr shot Alexander Hamilton — and that was across the river in New Jersey.

Before Saddam Hussein invaded Kuwait in 1990, I directed a White House study on the Strategic Petroleum Reserve. Should we add to the reserve? What were the chances of a war in the gulf or an OPEC boycott like the one in 1973? These events take place intermittently and are hard to predict. But we had to make some estimates. Likewise, in order to allocate our domestic defense resources, we have to estimate the odds of terrorist events on the ground, in the sky or at sea.

Here again, markets work better when they are deep and liquid — that is, with many participants and lots of transactions. This raises reliability and reduces the risk of manipulation. How deep and liquid could the market for terrorism futures be?

This was the problem faced by the Pentagon. To attract "investors," the Pentagon needed to offer a significant payoff. But with big payoffs, the incentive for market manipulation rises. And in the case of terrorism futures, market manipulation can show up not as a forged buy order but as a bullet.

Fortunately, existing markets already gauge worldwide risks. That's why the price of oil shot up to $38 per barrel in March before the war. Worried about civil unrest in southern Africa? Look at the South African rand or the price of gold. Professional investors regularly look at the interest rate spread between emerging market bonds and United States Treasuries to assess risk.

Before ridiculing the Defense Advanced Research Projects Agency, though, we should remember its mission: to finance and explore pathbreaking technologies that are not on the standard list of cocktail conversation. The agency started in 1958 as a response to the Sputnik launching, and backed speech-recognition technologies and antichemical warfare research long before they made headlines. Most famously, the agency developed the Internet.

Let's also remember that the defense of our country is serious business, demanding serious consideration of every idea that can help make America more safe — even ideas that can make Americans squeamish. The Pentagon and the C.I.A. require analysts, informants and spies to sometimes trick and swindle their counterparts.

Plato taught that the rulers of the Republic might sometimes be required to tell "noble lies" for the good of its citizens. And sometimes, he might have added, our government must keep from us some unsavory truths. We know we live in dangerous times. We don't necessarily want our government running a market that tells us, down to the last penny, just how dangerous they are.

Todd G. Buchholz, a former White House economic adviser, is author of "Market Shock."